Present Value: Saule Omarova discusses financial sector oversight and fintech
Present Value, an independent editorial project produced and hosted by Johnson students, had the pleasure of interviewing Saule Omarova, the Beth and Marc Goldberg Professor of Law at the Cornell Law School.
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The shortcomings of entity-based financial regulation
The sources of systemic risk in the modern, globalized financial system are numerous and often ill-understood. In the Present Value podcast, Omarova details how the logic of the U.S. financial regulatory structure focuses on the risk of individual financial institutions but fails to adequately monitor the system-wide sources of risk that result not only from size, but from increasing interconnectedness. She notes that historically, oversight of the financial sector has been based on the assumption that the risk held by each type of financial entity (for example, an investment bank or an insurance provider) could be assessed based on their industry-specific products and operations.
In this entity-based, “micro-level” approach, regulators evaluated risk based on the balance sheet of an individual institution (e.g. assessing the riskiness of a loan portfolio of an individual commercial bank). The drawback of such an approach is that regulators did not have the ability or authority to determine to what extent the value of the assets on that same balance sheet were dependent on the behavior of external actors in the system—rendering a true assessment of the risk level incomplete.
This oversight flaw begs the question whether the Dodd-Frank Wall Street Reform and Consumer Protection Act—the centerpiece of U.S. financial reform passed in the wake of the 2008 global financial crisis—solved this problem. Omarova contends that the answer is mostly “no.” In her view, Dodd-Frank merely “took the ‘micro level’ regulatory tools and simply tried to scale them up to a macro-level framework” without creating a framework with the capability to adequately evaluate systemic risk in the financial sector.
Oversight gap gives way to regulatory arbitrage
As a consequence of this remaining gap in financial-sector oversight, financial institutions now see the incentive and have the ability to engage in what Omarova refers to as “regulatory arbitrage,” which refers to the ability for a financial institution to exploit the silo-based regulatory framework (particularly within a financial holding company structure) and take advantage of the differences in the regulatory treatment of economically equivalent activities conducted in different subsidiaries.
Omarova notes in her research that one of the pernicious effects of regulatory arbitrage is that it potentially allows financial conglomerates to incur high levels of risk that are intentionally obscured from regulatory authorities, which are legally confined to specific jurisdictional silos. During the financial crisis of 2008, “what became evident was that sometimes problems that accumulate in certain parts of the financial market that are not directly overseen as part of the banking system…nevertheless are tied to the problems that are accumulating in the regulated banking sector,” she explained.
Toward a public-private balance in finance
A foundational theme of both Omarova’s financial system and fintech scholarship is the necessity of a “public-private” balance in the financial sector. In the United States, this balance has historically favored the private side; Omarova underscores that a weakness of Dodd-Frank was its unwillingness to meaningfully challenge that philosophy.
“Dodd-Frank does not actively seek to share the markets’ risk profile and to eliminate or control the ultimate sources of potential instability in the financial system in order to protect the broader public from failure of market forces,” she said. Instead, it relies on familiar tools such as disclosure and data reporting, registration, and capital adequacy requirements for financial intermediaries—all components of the incomplete micro-level approach. She expounds on this public-private balance concept in a comprehensive paper published in the Washington University Law Review, “Public Actors in Private Markets: Toward A Developmental Finance State,” co-authored with previous Present Value guest Robert Hockett.
The systemic risks of fintech
Some of Omarova’s most recent thought leadership extends the analysis of systemic risk to the development of financial technology, popularly referred to as “fintech.” In her wide-ranging paper “New Tech vs. New Deal: Fintech As a Systemic Phenomenon,” she asserts that while innovations in fintech have promise to deliver certain social benefits, the risks to systemic stability have been under-appreciated. Her analysis continues that “the fintech phenomenon has a broader significance than a ‘disruption’ in the prevailing modes of, or institutional channels for, delivery of specific financial services. Its arrival marks a potentially decisive shift in the fundamental political arrangement underlying the operation of the modern financial system, as it currently exists in most advanced markets.”
Finally, in Omarova’s Present Value interview she outlines the risks to consumer privacy, currency, and financial system stability that the continued development of fintech poses to the modern economy, given that “information has always been the lifeblood of the financial system.”
As the international debate continues about the implications of corporate concentration to consumer privacy, Omarova’s nuanced analysis of financial technologies is both essential and well-timed for those considering the role of finance and technology in modern society. Notably, she concludes that “the arrival of these new-generation technologies enables a potentially decisive shift in the underlying balance of the sovereign public’s and private actors’ relative powers, competencies, and roles in the financial system. By making transacting faster, easier, cheaper, and instantly adjustable to individual parties’ needs and preferences, new technology is empowering private actors to engage in virtually unconstrained financial speculation. Unless the public side proactively counters new technologies’ potentially destabilizing systemic effects, it may soon find itself in an impossible position of having to back up an uncontrollable and unsustainably self-referential financial system.” These considerations merit the attention of financial practitioners, policymakers, regulators, scholars, and the general public—that is, anyone with a stake in the continued stability of the financial system.
Omarova expands on the above topics and more in her full episode with Present Value. Listen, share, and subscribe!
About Saule Omarova
Saule Omarova, the Beth and Marc Goldberg Professor of Law at Cornell Law School, specializes in regulation of financial institutions, banking law, international finance, and corporate finance. Before joining Cornell in 2014, she was the George R. Ward Associate Professor of Law at the University of North Carolina School of Law. Prior to joining academia, Omarova practiced law in the Financial Institutions Group of Davis, Polk, & Wardwell, a premier New York law firm, where she specialized in a wide variety of corporate transactions and advisory work in the area of financial regulation. In 2006 and 2007, she served at the U.S. Department of the Treasury as a Special Advisor for Regulatory Policy to the Under Secretary for Domestic Finance.